LONDON, Oct 19 (Reuters) - The euro fell towards a two-month low on Friday after the European Union criticized Italy's spending plans, raising fresh concern over conflict within the common currency zone.

Political wrangling over the budget in heavily indebted Italy has seen the euro weaken over 1 percent versus the dollar this week.

In the first step of a procedure that could end with Brussels rejecting the budget and fining Italy, the Commission sent Rome a letter on Thursday calling a draft budget an "unprecedented" breach of EU fiscal rules.

The single currency fell to an intra-day low of $1.1433 close to a two-month low of $1.1432 hit on October 9.

Italy is the third-largest economy of the 19-country euro zone, and a crisis there could unsettle the entire bloc.

The gap between Italian and German 10-year bond yields reached its widest in 5 1/2 years after news of the Commission letter broke.

"The euro is already suffering considerably now, and that would be worse if the crisis really gets going, as the dollar is now providing attractive yields," said Ulrich Leuchtmann, a currency strategist at Commerzbank.

Analysts at MUFG said that if BTP yields moved notably higher "correlations could well strengthen and this would provide further downside pressure for the euro".

Investors have been pricing in the possibility that the tussle between Italy and the European Union will force the European Central Bank to be more cautious in removing stimulus.

Euro zone money markets are now not fully pricing in an interest rate rise from the ECB until October 2019. Earlier this week, they were projecting an increase next September.

The dollar index, a gauge of its value against major peers, was 0.2 percent higher at 96.091 on Friday, close to a two-month high of 96.155. The rise was driven by Thursday's decline by the euro, which accounts for 57 percent of the index.

Meanwhile, the British pound rose after EU negotiator Michel Barnier said a Brexit deal with the United Kingdom was 90 percent done but that hurdles remained.

Sterling rose to a day's high versus the dollar of $1.3038 , trading broadly flat. It also strengthened 0.1 percent against the euro to 87.9 pence.

The Japanese yen weakened 0.23 percent versus the dollar on Friday, to trade at 112.48.

A global risk-off mood has prevailed this week amid tension between the U.S. and Saudi Arabia, Italy's budget woes and U.S-Sino trade conflict.

China's economic growth in the third quarter slowed to 6.5 percent, its weakest since 2009 and below expectations, as a campaign to tackle debt risks and the trade war with the United States weighed on the economy.

The yuan changed hands at 6.9420 on Friday, trading down 0.1 percent versus the dollar, close to a two-month low.

"Expectations have increased for the Chinese yuan to depreciate towards its psychological 7 level against the USD," said Eugene Leow, rates strategist at DBS in a note. (Additional reporting by Vatsal Srivastava in Singapore, editing by Larry King)